Three American economists whose theories have helped guide corporate financial decisions and investors' strategies for two decades were awarded the 1990 Nobel prize in economics yesterday.
Merton Miller of the University of Chicago did pioneering work in assessing the use of debt as a source of corporate capital, while Harry M. Markowitz of Baruch College at the City Unversity of New York and William Sharpe of Stanford University created powerful new analytical tools for understanding investment risk and the way stock market investors make decisions.
The crucial part of Miller's message today, Miller said in a telephone interview, is that corporate debt, which financed many of the mega-takeovers of the past decade, "is a two-edged sword. It works fine on the way up, but it hurts like hell on the way down."
During the 1970s and 1980s, when many companies began to rely more and more on borrowing to finance expansions, mergers and takeovers, Miller's work was cited by some economists as providing the theoretical underpinnings for the transformation. But, as the falling profits and enormous interest payments of many heavily leveraged U.S. corporations show today, his work also emphasized the disadvantages of excessive debt financing.
"If companies had listened, maybe all that debt we experienced in the last couple of years might not have occurred," said Jeremy Siegel, professor of finance at the Wharton School at the University of Pennsylvania.
The prize-winners' work, especially that of Markowitz and Sharpe, also produced an equally clear message to investors: The more diversified an investor made his the investments, the better the balance between risk and return.
Of the various branches of economics, the teachings of corporate finance are far more widely used by business and investors than the more theoretical disciplines. The winners' work, among other real-world consequences, led to the creation of stock-index mutual funds, which spread investors' dollars among a wide range of securities.
"Only 40 years ago, finance was something that economists despised, because it had no theory or structure," said Franco Modigliani, who has done work with Miller and was the 1985 Nobel economics laureate. "One of the important things about finance is that each contribution has had a real impact on the world. It is used by firms, by investors, by advisers, by managers."
As always when the Nobel prizes are announced, the three men spent the day following their early-morning notifications amid phone calls, press conferences and champagne. Markowitz, in Tokyo on a teaching assignment, was still fielding phone calls after midnight; Sharpe disrupted a business conference he was attending at a Tucson hotel; and Miller had the press staff at the University of Chicago working full time on handling his appearances and telephone interviews.
James Tobin, Nobel economics laureate in 1981 for his work in the same general field of portfolio theory, praised the work of the three economists, but said they have some tough times ahead. "They are going to be expected to know everything about everything, not just about the issues on which they received the prize," Tobin said. "They will be bothered by reporters and invitations and autograph-seekers for a while, but it will die down. My advice is, be patient and you'll live through it."
The three economists, who will share the prize of roughly $700,000, did not work as a team, but each filled in different pieces of the puzzle in the 1950s, 1960s and 1970s.
"We wanted to give the prize for pioneer work, innovators," said Assar Lindbeck of the Swedish Academy of Sciences in Stockholm, which made the choice. " ... Each of them gave one building block" to the field of financial economics.
The work of Markowitz, 63, established a theoretical basis for allocating investment dollars, showing that risky investments made sense for investors if they were part of a diversified group, or portfolio, of securities.
Sharpe, 56, provided analytical tools allowing investors and portfolio managers to evaluate and control risk and return on investments, through margin borrowing and diversification, to put Markowitz's theory in practice. His concepts are widely employed by brokerage houses, institutional investors and other market professionals.
Sharpe said from Tucson that he tries to put his theories to work in his own personal investments. "I follow my precepts. I have a highly diversified portfolio. I try to tailor the risk and make investments appropriate to my age. It's pretty dull," he said.
Miller, viewing related questions from the corporate perspective, looked at the question of whether companies were better off financing their operations or expansions through borrowing or through issuing new stock. The answer depends on the assumptions, but Miller said some companies now are paying the price for excessive borrowing in the past.
"What really counts in running a firm is the underlying assets and how well they are managed. It doesn't matter too much what kind of capital structure you have," he said.
The choice of the three economists "sends the message that corporations have to stop playing games in terms of strategy and performance," said Grady Means, chief economist for the accounting firm Coopers & Lybrand. "You can't fool with balance sheets or income statements. ... You have to create real shareholder value on a global basis."